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Australia for income, but beware very high payout ratios

Charlie Aitken explains why he sees high dividend payout ratios, as was the case with Telstra, as a clear warning sign to investors.

I’ve long believed that the right equity strategy is “Australia for income, international for growth”. The “lost decade” in Australian equities confirms this view.

While it’s nice to see the ASX200 recapture the 6000-point level, it’s worth reminding ourselves the last time the Australian benchmark was here was February 2007. In that decade at the index level you have experienced no capital growth in Australian equities, but you did collect a cumulative 44% in dividend yield over that decade (plus franking). It really was a “growthless yield” decade in Australian equities and I broadly expect that to continue.

The last time the ASX200 broke through the 6,000 mark was in February 2007 and back then John Howard was Prime Minister, Barack Obama had just declared he would run for President and the first iPhone was yet to be released. Below is a snapshot of how the financial landscape has changed since then.

Source: JP Morgan

Clearly the biggest change domestically in the “lost decade” was the RBA cash rate dropping from 6.25% to 1.50%. Yes, we all tend to forget, but cash rates fell -76% over the last decade and unsurprisingly Sydney house prices rose +121.4% over that period.

Similarly, with cash rates falling by -76%, the search for investment yield became the dominant theme in equities. It remains so to this day, with investors paying record prices for pretty much anything that has an attractive grossed up yield vs. cash. In fact, you could argue investors are pricing many Australian stocks simply on their yield.

It is a strange world when investors are buying bonds for capital gains and equities for yield! That’s not how it’s meant to be, but my view is we are past the bottom of the interest rate cycle globally and interest rates will start rising at both the cash rate and bond yield level.

If that proves right, then we all need to be thinking a little less about dividend yield in equities and a little more about capital growth or traditional measures of valuation, not dividend yield alone.

I also think it’s an opportune time to refocus on picking stocks. While this week the index itself got all the headlines, it’s always worth reminding yourself that it is a market of stocks, not a stock market.

Similarly, I don’t think it’s the time for passive strategies. Look where “buying the index” got you in Australia over the last decade: nowhere.

When indexes were invested they were devised as a way of measuring professional investors’ performance. I don’t think anyone ever thought back then what the benchmark itself would be invested in. But therein lies the opportunity nowadays for high conviction stock-picking inside what is a “passive bubble”.

Like the last decade, inside the index itself will be tremendous winners and tremendous losers. When I’m presenting to investors in my fund I always say you should look at the products your children and grandchildren are using as they are most likely the growth stocks of the next decade. You can definitely use your powers of observation in the investment process, particularly when technology and businesses are changing so rapidly.

Remember, it was only 10 years ago the first Apple iPhone was launched while Facebook was a photo sharing network in a college dorm. If you look around you today there will be other huge changes over the next decade and that is why I believe it is outright DANGEROUS to invest in companies that aren’t investing enough in their future growth prospects.

You need to be wary of very high dividend payout ratios. Companies with very high dividend payout ratios are more than likely not reinvesting enough in future growth or reinvesting in increasing the moat around their business in times of rapid disruption. I see very high dividend payout ratios as a clear warning sign now and I think Telstra has been a classic example of the above.

TLS obsession with pleasing retail shareholders via very high dividend payout ratios has been the single biggest problem with the company. They have given retail investors what they wanted during a period of record low cash rates, and previously saw their share price rise inverse to that yield, but now they are GROWTHLESS and find themselves still held hostage to that yield.

Remember, you want dividend GROWTH not just dividend YIELD. High yield usually means high risk. High yield usually means unsustainable yield.

Another large cap Australian stock I believe is now held hostage to its very high dividend payout ratio and large retail shareholder base is Wesfarmers.

I simply don’t believe WES has the ability to substantially grow its business, or do entrepreneurial value added transactions, while it’s paying out such a high percentage of its profits and maintaining the attractive 5 % fully franked FY18 dividend yield.

In FY18, consensus forecasts see WES generate EPS of 252c and payout dividends of 221c, an 87% dividend payout ratio.

In effect, WES, which had every chance of becoming Asia’s Berkshire Hathaway, has become a dull “growthless yield” stock whose share price has basically gone sideways for the last five years. This is the chart of a classic “growthless yield” stock below.

Wesfarmers’ share price since January 2013 till October 2017

Source: nabtrade (as at October 2017)

Wesfarmers’ growthless yield, but is the yield sustainable?

While many people say “Wesfarmers is a great company”, my view is Wesfarmers WAS a great company”. They were at their best doing deals like buying Howard Smith, creating Bunnings and then buying Coles etc. Nowadays I believe there are completely held hostage by their retail investor base and demands for dividend yield.

Even spending one billion pounds on what is most likely a sensible long-term move in to UK large format hardware gets shareholders anxious about future dividends. WES shares have underperformed since making a relatively small step into the UK hardware market, a classic sign of investors holding them hostage for dividends.

Interestingly, the long serving CEO and CFO are both departing WES. One wonders whether there was some frustration in their decisions as this company is simply not the market leading company it was a decade ago.

The question then becomes – is WES a “yield trap”? Is the 87% dividend payout ratio unsustainable? Will the board find its mojo again and sacrifice some yield for growth?

My view is WES needs to find a better balance. They need more growth and need to sacrifice a little dividend yield. Otherwise you can be certain of another five years of no capital growth and simply receiving the dividend and franking credits.

But don’t think everything is assured. There are real competitive threats and margin attacks brewing in many of WES’s major businesses. This actually could prove a yield trap just like Telstra did. There are similarities.

So today I stand by my long-held view of Australia for income and international for growth. Australia does have a few international growth stocks such as ALL, TWE, CSL etc, but more broadly you do need to invest outside Australia to find structural growth themes.

Just be careful buying very high dividend payout ratios in Australia: they can be very dangerous. This is particularly so at the low point of interest rates globally and locally.